How to trade Forex
Currency trading is always done in pairs. One currency is bought while another is simultaneously sold. These currency pairs, referred to as a “cross”, can be thought of as an instrument, able to be bought or sold.
• How currency pairs are quoted
• The two prices of a currency pair
• Where are the Forex exchanges?
• When is the Forex market open?
• Is Forex trading expensive?
• What strategies can I employ in my trading?
• How do I manage trading risks?
• How often do I trade?
• How do I analyse the market to make decisions?
• What are examples of bullish and bearish trading strategies?
How currency pairs are quoted
The US dollar, as the world’s dominant currency, is usually considered the base currency for quotes, so they are expressed as a unit of
US$1 per the other currency in the pair. The Euro, Great Britain Pound and Australian Dollar are the exceptions to this and are quoted as dollars per foreign currency. The most commonly traded crosses are the so-called “majors”, including EUR/USD, USD/JPY, USD/CHF and GBP/USD.
The first currency in the pair is the currency being bought/sold and is referred to as the base currency. The second in the pair is the currency referred to as the counter currency.
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The two prices of a currency pair
As with all financial products, Forex quotes include a “bid” and an “ask”. The bid is the price at which a market maker (such as MFGtrader) is willing to buy (and the trader can sell) the base currency in exchange for the counter currency. The ask is the price at which a market maker is willing to sell (and the trader can buy) the base currency in exchange for the counter currency.
The difference between the bid and ask prices is referred to as the spread.
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Where are the Forex exchanges?
There are no central trading locations or “exchanges” for the Forex market as there are with Equities or Futures. Trading is done entirely through various networks such as Banks/Financial Institutions, individuals etc.
There are actually two Forex markets. The primary market is known as the “Interbank” market because historically it has been dominated by banks, including central banks, commercial banks and investment banks. The participants in this market have grown over the years and now also include other large financial institutions, insurance companies and large corporations. Investors in this market deal in large quantities and have a very high net worth.
In more recent history, the secondary “over the counter” market has developed that permits retail Forex investors to trade. Retail investors trade with brokers using systems such as those offered by MFGtrader. Brokers in turn trade with the large institutions in the Interbank market.
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When is the Forex market open?
Unlike other financial markets, Forex is a 24-hour market and investors can respond to news and events by trading at any time they occur. The market is open from Sunday
17:00 EST (5:00PM New York), to Friday 16.00 EST
(4:00PM New York).
Please
note: MFGtrader trading hours are from Sunday
17:10 EST (5:10PM New York time), to Friday
16:00 EST (4:00PM New York time).
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Is Forex trading expensive?
Investors are able to trade as frequently and actively as they like without worrying about excessive transaction costs because most Forex brokers typically do not charge commission.
The minimum amount you will need to invest in your Forex account will vary between brokers and the margin requirement you are comfortable with. The margin is the collateral required for a position and allows you to take on a leveraged position with a fraction of the equity necessary to fully fund the trade. In equity markets this margin is usually
higher, but your Forex account can allow you high leverage of as low as 1% (100:1).
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What strategies can I employ in my trading?
There are essentially two interdependent strategies, known as “long” and “short” positions. When a trader buys a currency at one price and aims to sell it later at a higher price, this is known as a long position. The trader is said to be “long” in the currency he has bought and the strategy is to benefit from a rising market. A short position is one in which a trader sells a currency in anticipation that it will depreciate and he will buy it back later at a lower price. The investor is said to be “short” in the currency he sells and will benefit from a declining market.
It’s important to recognise that because of the symmetry of currency transactions, every Forex transaction requires a trader to simultaneously go long in one currency and short in the another.
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How do I manage trading risks?
The first step in managing your Forex account is establishing a margin which you feel comfortable with, based on your appetite for risk. Although a margin of 1% gives enormous leverage offers maximum potential profit, the potential for loss is equally great.
Two effective risk management tools in Forex trading are limit orders and stop loss orders. These can both be easily executed because of the liquidity of the Forex market.
Limit orders are placed with the intent of securing a preferred rate for an existing position. The open position is closed when the pair's price reaches the trader's predetermined level. For a long position, a limit order is placed above the current price. If a trader holds a short position, then a limit order will be placed below the current price.
A stop loss order automatically liquidates a position at a predetermined price. This limits potential losses by a trader if the market moves against their position.
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How often do I trade?
Trading activity varies from investor to investor. Generally Forex trading is quite active, and the average small to medium trader may trade as often as 10 times a day. Approximately 80% of all Forex trades last 7 days or less, and more than 40% last less than 2 days.
An open position is one that is live and ongoing and while it is open its value will move according to changes in the exchange rates in the market. Positions remain open until one of the following occurs:
- The trader closes out by conducting an equal and opposite trade in the same currency pair.
- The specified stop loss is triggered.
- The trader closes the position and opens another one which he feels has better potential.
Positions opened and closed during normal trading are referred to as “intraday”. Those which are still open at 5.00pm EST are rolled over by the broker and the trader earns/pays interest based on the interest rate differential between the two currencies. These are referred to as “overnight positions”.
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How do I analyse the market to make decisions?
There are two common approaches to analysing the currency market and in practice a blend of both is generally used to get best results.
Fundamental analysis focuses on the economic, social and political influences that drive demand and supply. It seeks to predict price movements by understanding the macroeconomic factors such as economic growth, unemployment, interest rates and inflation, fundamental analysis which cause the movement. This approach is favoured by longer term investors.
Technical analysis predicts future price movements based on studying patterns in price movements in the past. Charts are used to identify trends and find profit opportunities. This is a more short-term view of currency pricing and is strongly favoured by short-term investors.
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What are examples of bullish and bearish trading strategies?
1. Trading on a bullish view
Assume that you start with a clean slate and that the current GPB/USD rate is 1.9855/60.
You expect the pound to appreciate against the US dollar, so you buy a single lot of 100,000 GBP at the offer price of 1.9860 USD.
The value of the contract is 100,000 X 1.9860 = $198,600. The broker wants margin of say, 2.5% in USD, so you must ensure that you have a deposit of, at least 2.5% of 198,600 USD = 4,965 USD in your margin account. GBP/USD duly appreciates to 1.9900/05 and you decide to close out your position by selling your sterling for US dollars at the bid rate. Your gain is:
100,000 X (1.9900 - 1.9860) USD = 400 USD, the equivalent of 10 USD per point.
Your rate of return is 400/4965 = 8.05%, on an exchange rate movement of less than 0.2%. This illustrates the positive effect of buying on margin. Had GBP/USD fallen to 1.9830/35, your loss would have been: 100,000 X (1.9860 - 1.9830) USD = 300 USD, a loss of 6.04%. 2. Trading on a bearish view
You expect sterling to fall from GBP/USD = 1.9855/60 so you decide to sell 1 lot of GBP/USD.
The value of the contract is 100,000 X 1.9855 USD = 198,550 USD. You have effectively sold 100,000 GBP and bought 198,550 USD.
Your broker requires say, 2.5% of 198,550 USD as margin in US dollars, namely 4,963.75 USD in cash. You must ensure that you have a deposit of at least 4,963.75 USD in your margin account.
GBP/USD falls to 1.9800/05 and you are sitting on a paper gain of:
100,000 X (1.9855 - 1.9800 USD) = 550 USD.
Your 550 USD paper gain is credited to your margin account where you now have 5,513.75 USD. This enables you to maintain open positions worth 220,550 USD.
However, GBP/USD starts to rise. When it reaches back to 1.9855, the excess fund over and above the margin required is spent.
The the broker will liquidate your position.
Now you have no more open positions, you have 4,963.75 USD in your trading account.
(The above example is for illustration only. Typically, the customer would have much more funds than the margins required for a particular position, as deposits in his account. If not, then the customer would have a shortfall of margin as soon as the market moves against him and the position(s) would be liquidated immediately.)
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